The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Saturday, February 2, 2013

From financial 'failure prevention' to 'failure containment': how regulators destroyed global financial system

In an interesting Guardian column, Leo Panitch looks at Tim Geithner's legacy through the prism of the shift in regulatory policy from financial 'failure prevention' to 'failure containment'.

This shift is best embodied in former Fed Chairman Alan Greenspan's policies that Professor Paul Krugman summarized as 'it was not the role of financial regulators to prevent or pop financial bubbles, but rather to clean up afterwards to limit the damage their popping causes.'

I would like readers to take a moment to think about the implications of shifting from a policy of preventing financial failure to trying to limit the damage by mopping up afterwards.

First, the financial system under the FDR Framework was designed so that regulators would perform certain tasks to prevent a financial crisis. Specifically, financial regulators were given the task of ensuring that market participants had access to all the useful, relevant information in an appropriate, timely manner so they could independently assess this information and make fully informed decisions.

When regulators effectively stopped being in the business of preventing a financial failure, they let opacity reappear across wide swaths of the financial system including both banks and structured finance securities.

The result of this opacity was our current ongoing financial crisis.

Second, if the regulators were no longer going to prevent a financial crisis, then who was going to pay to clean up afterwards?

Under the FDR Framework, who "pays" when an investment goes down in value is well known. It is the investor who pays as they are responsible for all losses on their exposures.

Under the mop up after a financial crisis, who "pays" is the taxpayer and, to the extent that policies like austerity are adopted, a country's citizens. Who doesn't pay is the investors or the individuals responsible for the financial crisis.

Third, if the regulators are no longer going to prevent a financial crisis, then what is the financial system suppose to look like after they have cleaned up after the financial crisis?

Under the FDR Framework, regulators would clean up the financial system so that transparency, specifically valuation transparency, has been brought to all the opaque corners of the financial system.

Under the mop up after a financial crisis, the focus would be on adding more complex rules and regulatory oversight while providing additional meaningless price transparency. In short, opacity would still exist across wide areas of the financial system and the financial system would still be prone to the next financial crisis.

The legacy of the policy of financial containment is that not only does it make the financial system more prone to a crisis, but it ensures that a crisis occurs more frequently.

Regular readers know that your humble blogger has been advocating a return to the policy of failure prevention and adherence to the FDR Framework. It worked successfully for 7+ decades in preventing a financial crisis and has been shown to be successful at ending financial crises.

Perhaps the most important report on what the Treasury was up to in the 1990s – prepared in the teeth of some of most dangerous financial crises of the mid-1990s, and published as American Finance for the 21st Century in late 1998 in the wake of the Asian crisis – made a sharp distinction between the old practice of "failure prevention" and the new one of "failure containment".

To persist in trying to make "the financial system safer by tying the hands of institutions will inevitably put a damper on innovation, at considerable cost to the economy as a whole and potentially to America's world leadership in financial services."

Supervision and regulation needed to be of a kind that supported the financial sector's expansion – and insofar as its "mercurial growth" inevitably gave rise to financial crises, the main goal of financial policy should primarily be "failure containment".

Superintending global finance to this end was always a multilateral exercise, but one in which the Treasury was very much primus inter pares....

Please re-read the highlighted text as the policy of 'failure containment' was a necessary condition for the financial crisis which began on August 9, 2007.

This policy of financial containment is a policy effectively written by the banks for the banks. It removes from them the downside from losses on dud assets or proprietary bets and places these losses on society.

In fact, Geithner's financial stability plan largely followed what had gone before.

The main goal, as he told bankers from 27 countries at a 2011 American Bankers Association meeting, remained to find "better ways of managing the inevitable failures that will happen in competitive markets", which above all meant recognising that "the challenge of reducing the risk of contagion from a financial crisis requires much more global co-ordination internationally than has ever been the case".

As the FDR Framework based system is designed, the cost of those inevitable failures that will happen in competitive markets is borne by the investors, including banks.

With the policy of financial containment, these losses are now shifted to society.

Of course, what also made "failure containment" especially challenging was how to handle Congress at home.

A favourite phrase inside the Treasury, as Geithner rose through its ranks in the 1990s, was that of Congress "cutting off the water to the fire department when the city is burning down".

Yet this Congressional opposition had in every instance been overcome. Indeed, Robert Rubin accurately described Congress's resistance to the Treasury's loan to Mexico to stop the 1995 peso crisis (the largest bailout of a sovereign in history to that point) as "meant to oppose us without actually stopping us".

To its credit, Congress sensed that putting the cost of the financial crisis on the taxpayers was not right. This is why it fought Treasury.

It probably never occurred to Congress that Treasury was at the vanguard of the fight to have financial regulators abandon their role in 'failure prevention'. Had Congress seen Treasury's abandonment of failure prevention, Congress would have realized that someone needs to pay for cleaning up after the financial crisis and that someone should not be taxpayers.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.